The New Pension Legislation and a Challenging Market

First, I want to "welcome" all our old-time subscribers who were a subscriber
to MarketThoughts.com when it used to be a free commentary. As I had mentioned
in our discussion forum,
this week's commentary will also go to our old-time subscribers for the first
time in 10 months. As well as to just let you all know that we are still around
(although I have now moved from Houston, Texas to Los Angeles, California)
- the primary reason for us sending this commentary out to as many people as
possible is this: The impending passage of the Pension
Protection Act of 2006.

Before we start our discussion, let us do some house-cleaning with regards
to our DJIA Timing System: Our 50% long position in our DJIA Timing System
that we initiated on the afternoon of July 18th (at a DJIA print of 10,770)
was exited last Thursday morning (August 10th) at a DJIA print of 11,060. A
real-time email was sent to our subscribers announcing this shift - and the
justification for this shift was discussed in our mid-week
commentary last week ("Is Our Short-Term Scenario Busted?"). At this time,
this author is still long-term bullish on the U.S. domestic, "brand name" large
caps - names such as Wal-Mart, Home Depot, Microsoft, eBay, Intel (which, as
I have discussed over the last few months, will regain a significant chunk
of microprocessor market share from AMD), GE, American Express, etc. But in
the meantime, we are still going to sit on the sidelines, given a slowing U.S.
economy (for the first time in 14 months, the ECRI Weekly Leading Index has
ventured into negative territory), a tightening Fed (the effect of the latest
rate hike campaign is still yet to be fully felt), horrible market technicals,
the lack of an oversold condition in the major market indices, and the fact
that we are way overdue for a 10% correction in the Dow Industrials or the
S&P 500. Of course, if we are not careful - then the current economic slowdown
we are experiencing may very well turn into a consumer-induced recession, but
for now, it is still too soon to tell.

Let us now get to business. Once it is signed into law by President Bush,
the Pension Protection Act of 2006 will include the most sweeping reforms in
the pension world since ERISA was signed into law in 1974. A majority of US-based
employees will soon see changes in their 401(k) or 403(b) provisions, such
as a faster vesting schedule with regards to employer contributions (effective
after December 31, 2006), and the ability to roll over your 401(k) or 403(b)
distributions to a Roth IRA starting on January 1, 2008. In addition, employers
(beginning January 1, 2007) must offer at least three different investment
options besides employer securities, and 401(k) participants must be allowed
to diversify their employer contributions to other investments besides employer
securities (this apply to companies who grant employer securities for their
employee match).

However, the most sweeping changes did not apply to defined contribution plans
(which consists of 401(k) plans), but to defined benefit pension plans. The
declining popularity of defined benefit pension plans among corporate America
over the last couple of decades has been well publicized. Defined benefit pension
plans obviously has a place in corporate America, but in this day and age,
it is quickly being recognized as a dinosaur - by finance as an unnecessary
drag on earnings consistence and by the HR department as an ineffective tool
in talent retention. For readers who are over age 40 and who participate in
a defined benefit pension plan, you should know this:

In general, defined benefit pension plans tend to reward long-time employees
(by the basis of their formulas) - especially those who have been steadily
promoted through the ranks and who ultimately retire from the same company.
In other words, the accruals in defined benefit plans are essentially "backloaded." The
exception to this rule is if the defined benefit is in the form of a cash
balance or a pension equity plan.

For long-term employees (those who spent 25 to 30 years of their working
lives with the same company), the "income replacement ratio" could get
as high as the 45% to 60% range if one stays until normal retirement age
and if benefits are above average. That is, the pension benefit that one
will receive from the company after one retires could essentially "replace" 45%
to 60% of their average income over the last three or five years preceding
his retirement. Coupled with Social Security benefits, and one essentially
does not need to save too much of his or her money for retirement during
his or her working life. In other words, defined benefit pension plans
can be very rich for long-timers.

In light of the declining popularity of defined benefit pension plans in corporate
America, readers who are close to retirement or who anticipate staying with
the same company until you retire should find out more about the provisions
of your defined benefit pension plan - should your company offers one. IMHO,
the Pension Protection Act of 2006, should further serve as an incentive for
corporate employers to terminate or freeze their pension plans, given the following:

The new law would tighten the screws on the ability of pension plans to "smooth" their
liabilities (e.g. using a four-year average interest rate to discount future
cash outflows to calculate liabilities) and assets. Going forward, the
smoothing period will generally be limited to a maximum of 24 months. We
could argue all day whether this represents better disclosure, but what
we know is this: The new limitation on smoothing liabilities or actuarial
value of assets will increase the volatility of required pension contributions
and pension expense, and this will further discourage CEOs and CFOs from
starting new or keeping their current defined benefit plans.

As of the beginning of this year, the required annual insurance premiums
to be paid to the PBGC from defined benefit pension plans had been increased
from $19 per participant to $31 per participant. Going forward, this new
$31 per participant premium will be indexed to inflation. Not only will
this increase represent a higher opportunity cost for employers who do
possess a defined benefit pension plan, this will increase administrative
costs as well.

Other provisions of the new law includes adopting different interest rates
to discount liabilities depending on the timing of the cash flows and the
shape of the corporate yield curve - not to mention more disclosure items
such as an expansion of the IRS Form 5500 and an additional "funding notice" to
the PBGC 120 days after the end of the plan year. In other words, the administrative
costs of keeping a defined benefit pension plan are set to increase significantly
going forward.

Of course, there are always ways to mitigate volatility and uncertainty in
pension plan contributions and pension expense (please email me at hto@marketthoughts.com if
you are a pension plan sponsor and want to find out more about this) - such
as utilizing liability-driven investing strategies (e.g. immunization) or diversifying
your asset strategies into "portable alpha," hedge funds, private equity funds,
or by utilizing a combination of derivative instruments. But at the same time
- many of these strategies can get quite complex, and many CFOs (especially
those who are administering small plans) may not have the expertise to deal
with them at the end of the day. Bottom line: In light of what I have just
discussed, there is a good chance that the decline of defined benefit pension
plans will continue going forward.

Again, for those readers who are age 40 or over and who participate in a defined
benefit retirement plan, please find out more about the provisions of your
plan and please discuss this with your fellow co-workers. Know your options,
and definitely plan ahead since there is a real chance that your defined benefit
pension plan may not be there for you when you retire (unless you are working
for one of the big oil & gas companies). In virtually all cases, a company
will provide more incentives in their 401(k) plans should they choose to freeze
their defined benefit pension plans, and in the majority of freezes, older
workers who are approaching retirement will always be worse off under the new "scheme." Should
you find out that the company you are working for are undergoing HR or benefit
changes, definitely strive to learn more or even actively partition for the
continuation of your defined benefit pension plan (e.g. some companies have
created a "two-tier" system where "grandfathered" workers can continue to stay
in the defined benefit pension plan while new hires only receive benefits in
their 401(k)s).

Let us now get back to the markets. As the title of this commentary suggests,
the market has certainly been very challenging since the May 9th to May 10th
top - as exemplified in the "volatility" of our DJIA Timing signals over the
last few months. The good news is that our DJIA Timing System has "made money" overall
- even though we were definitely too early when we started to establish a short
position back in late January (our final short position was established on
May 9th at DJIA 11,610). Last week at this time, this author was looking for
a significant rally after the Fed has signaled it was pausing - but it was
not to be. Since the market has always rallied *initially* after the end of
a Fed rate hike campaign, this author had concluded that a rally was inevitable
- especially given the bearish sentiment that had been prevalent among retail
investors. But alas, the rally we had been looking for did not emerge - and
it is now back to the drawing board for this author. Since our number one priority
is capital preservation, this author also decided to take our 50% long position
in our DJIA Timing System off the table and stay on the sidelines for now.

As we have mentioned many times in our past commentaries and in our discussion
forum, it is now a battle between two strong opposing forces - one being the
analysts and strategists (such as TrimTabs) who are calling for an inevitable
15% to 20% rally from current levels and the other being the folks who are
calling for the beginning of a cyclical bear market (such as Lowrys). One service
is citing the unprecedented levels in corporate buybacks and cash acquisitions
in supplying liquidity to the stock market, while another service is citing
the all-time high spread between its buying power and selling pressure indices.
From this and from all the indicators that this author is watching, there is
no doubt that we are seeing significant capitulation among retail and pension
fund investors (the latter "diversifying" away from domestic equities into
emerging markets, commodities, hedge funds, etc.) - even as both corporations
and private equity investors are snapping up these same shares en masse.

Throughout history, the latter group has nearly always been right - but the
$64 billion question is: At which point will they be proven correct, and can
the capitulation among retail and pension fund investors get any worse?

Answer: It can always get worse. Consider the following:

Based on the valuation of the popular large-caps and retailing shares,
there is no doubt that the market has already priced in a significant economic
slowdown for these shares - a slowdown which this author has been looking
for since the beginning of 2006. But should the Fed go far (and we still
do not know if the Fed has gone too far yet), there is a chance that we
may actually see a consumer-induced recession. In such a scenario, the
market and retailing shares can definitely decline much further than they
already have (more to come on the risks of a recession later in this commentary).

Even though our sentiment indicators have been flashing several bearish
readings over the last few weeks (which is bullish from a contrarian standpoint),
this has not totally been confirmed by some of our other overbought/oversold
indicators, such as the equity put-call ratio, the NYSE ARMS Index, the
McClellan Summation Index (for both the NYSE and the NASDAQ Composite),
and so forth. In order to sustain a 15% to 20% rally going forward, one
will need to have a very solid bottom in place, and we have not had that
so far.

The rallies off the mid June and late July bottoms have been very weak
- both in breadth and in volume. One of the greatest speculators of all
time, Jesse Livermore, once said that to never try to short or sell at
the top, but only at points where the rallies have failed or are weak.
Based on Livermore's shorting methodology, the rallies off the mid June
and late July bottoms were good shorting opportunities - and these signals
have not been reversed yet at this time (either through a "fully oversold" condition
or a significant increase in "buying power").

Again, the number one priority when it comes to investing or trading is capital
preservation. And based on this philosophy, this author is going to stay on
the sidelines for now (for those who don't trade on margin and who have a very
long-term investing horizon, etc., this is now a good time to start nibbling
on the domestic large-cap brand names such as those I mentioned above).

Let us now look at what - in this author's mind (as of tonight) - will constitute
a "fully oversold" situation. Firstly, let's consider the NASDAQ McClellan
Summation index. Historically, both the NYSE and the NASDAQ McClellan Summation
Indices have best been used as an overbought/oversold indicator (particularly
as an oversold indicator). The following is a historical weekly chart of the
NASDAQ Composite vs. the NASDAQ McClellan Oscillator vs. the NASDAQ McClellan
Summation Index courtesy of Decisionpoint.com:

As mentioned on the above chart, the NASDAQ Composite McClellan Summation
Index is now sitting at a highly negative/oversold level of -715.83. But given
the horrible action in the NASDAQ ever since April, this author is going to
hold off until this indicator gets oversold - preferably until it gets near
the -1,000 level. This would put it on par with the oversold readings experienced
during the August 2004 and April 2005 bottoms. In terms of points on the NASDAQ
Composite, I would not be surprised if it declines a further 100 or 150 points
before we experience a significant bottom.

Henry To, CFA, is co-founder and partner of the economic
advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence
Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC,
and provides a twice-a-week commentary designed to educate subscribers about
the stock market and the economy beyond the headlines. This commentary usually
involves focusing on the fundamentals and technicals of the current stock market,
but may also include individual sector and stock analyses - as well as more
general investing topics such as the Dow Theory, investing psychology, and
financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted
his friends and associates about the huge risks created by the historic speculative
environment in both the domestic and the international stock markets. Through
a series of correspondence
and e-mails during January to early April 2000, he discussed his reasons
and the implications of this historic mania, and suggested that the best solution
was to sell all the technology stocks in ones portfolio. He also alerted his
friends and associates about the possible ending of the bear market in gold
later in 2000, and suggested that it was the best time to accumulate gold mining
stocks with both the Philadelphia Gold and Silver Mining Index and the American
Exchange Gold Bugs Index at a value of 40 (today, the value of those indices
are at approximately 110 and 240, respectively).Readers who are interested
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